For chief executives in New York, London, Tokyo, Sao Paulo, Sydney and, yes, even, Mumbai, creating, managing and distributing shareholder wealth has become a mandatory and ineluctable task. In this year's fifth BT-Stern Stewart Study we have enhanced the sophistication of our research and examined the wealth creation performance of 500 large listed companies across 20 sectors in India over the five-year period from the end of 1998 to the end of 2003. ONGC and Reliance Industries lead the pack ahead of familiar names like Infosys, Ranbaxy, ICICI Bank and HDFC. Interestingly, not-so-fashionable names like sail, SBI, Nalco, Grasim, TISCO, Tata Motors, GAIL, and SCI, also jostle for space on the honours list. While companies like HLL, ITC, Nestle (indeed the fast moving consumer goods sector in general) and Zee Telefilms find themselves much lower down the list.

So how did we measure wealth creation?

Investors and managers scrutinise wealth creation performance with a variety of metrics over different periods: quarterly, annual, and several years. As legendary investor Warren Buffet puts it: ''We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.''

We have defined Wealth Added as the extent of capital appreciation in the market value of equity of the firm netted for new equity issuances plus the extent of cash returned to shareowners in the form of dividends or equity-buybacks, less an opportunity cost charge equal to investor's cost of equity expectations. Whether we like it or not, changes in the market value of a company's equity are certainly at the heart of any Wealth Creation metric. It is clear that in the short to medium term, executives cannot fix or control the impact of various extraneous factors on movements in the share price of their company. But they can, to some extent, steer its long-term direction through their activities and over a sufficiently long-term period, share prices do reflect the investors' judgment of managerial effectiveness in the firm. Managers can influence how their company is organised, uses capital and operates-and thus, how investors can expect it to perform in future.

Which is why we examined the wealth flow performance over the five-year period from the end of 1998 to the end of 2003. We chose five years (as opposed to one or three), so that the findings would better take account of long-term performance and thereby give a more nuanced picture well estranged from the daily market clamour. We considered only those companies that had a listing record during the aforementioned period. Inevitably, certain familiar names with a more recent listing record like i-flex, Bharti TeleVentures, HCL Technologies, Mphasis-BFL, and Punjab National Bank were excluded.

Subir Raha/CMD/ONGC: Developing value-oriented growth prospects

Oil & gas, utilities, transportation, financial services, and metals & mining have emerged as the largest wealth creating sectors

Through this study, we have attempted to explain how effective India Inc. has been at creating shareholder wealth. How does the absolute wealth flow delivery of companies compare vis-à-vis investor expectations? What strategic actions did value creators undertake? How does the creation of shareholder wealth vary across industry sector? Are there any implications from the study that can be applied more broadly to help chief executives manage more effectively for wealth creation?

Top Performers By Industry

Surprisingly, the largest wealth creating sectors are the industrials-oil & gas, utilities, transportation, financial services, and metals & mining. On the other hand, growth-oriented sectors like leisure, telecom, and FMCGs have destroyed shareholder wealth.

What accounts for this dichotomy? Because market values are forward looking and include an expectations premium, market prices over the medium-term are driven more by differences in actual performance vs. expectations or by changes in expectations, than by the strength of actual fundamental performance alone. Thus, exceeding investor expectations is not merely about enhancing absolute wealth flows-it requires outperforming investors' expectations by converting currently embedded expectations into observable profitability while investing to build even more future expectations. And when the expectations rise to stratospheric levels, good companies can struggle to deliver wealth flows over and above shareholder expectations, despite continuing to deliver impressive operating results. This has contributed to the bane of the Consumer Staples sector in general and HLL, in particular.

Understanding Wealth Added

Wealth Added takes into account the four main components of wealth generation: profitability, prospects, financing, and the required return. The building blocks with which we use to construct Wealth Added are readily available.

Wealth Added = [Change in Value of Profitability + Change in Value of Prospects - Financing] - Required Return

Let us take the first two: the value of profitability, and of prospects. Whether it is an ongc, Infosys, hll, Ranbaxy or sail, the task for senior management of any firm to create wealth for their investors is remarkably the same and similar to searching for the proverbial gold mine: develop growth prospects that can create value (i.e. eventually deliver above cost of capital returns). And to, over time convert these prospective gold mines into observable profitability, while ideally simultaneously generating new prospects that can be converted into profitability in the future.

The enterprise value (EV) of the firm is equal to the market value of the equity and the market value of the debt or the present value (value today) of all future free cash flows. EVA analysis can be applied to disaggregate a given enterprise value at any time to explicitly derive investor expectations for future growth. We begin by asking what would a company be worth if it continues to generate the current level of operating economic profits (EVA) forever in the future. That steady stream of future EVAs is discounted back to today's terms at the company's cost of capital (the blended cost for both debt and equity). To this we add the total economic capital employed in the business. This reflects the company's value if it were to maintain its current level of profitability forever. We call this the value of the Current Operations Value (COV) or the value of profitability. However, the enterprise value at any point of time comprises an expectations premium over and above the current profitability. The difference between the enterprise value and the COV, therefore, reflects the markets expectations for future growth. We term this as the Future Growth Value (FGV). The computation for ONGC is shown here (See ONGC: Tracking Wealth Added).

Mukesh Ambani/CMD/Reliance: Balancing profits and prospects

Companies such as ONGC and reliance led the pack in wealth creation

The aim of any company should be to convert prospects into profitability, while generating further prospects over time. Companies, which generate high prospects and high profitability, are outstanding performers; companies, which can only muster low prospects and low profitability, are under performers.

The matrix shown here (See Prospects and Profitability: A Snapshot), gives a five-year snapshot of how some sectors have managed their prospects and profitability. Sectors like paper & forest products, transportation and utilities are outstanding performers. Sectors like IT, construction materials, media, metals & mining and pharmaceuticals are future performers. The expectations of growth reposed by investors in these sectors have significantly risen-the challenge for companies in these sectors would be to convert this promise of growth into fundamental performance. For some, the expectations embedded in their valuations may not be in line with their ability to deliver. Sectors like oil & gas and automotive are current performers. Companies in these sectors may be improving their economic profitability today, but the market has low expectations of their ability to grow or sustain their current levels of performance in the future. Finally, sectors like hotels & leisure, FMCGs, and telecom have fared badly in both parameters.

The third element is financing. Issued equity and debt, plus retained cash, provide the funds for a business; dividends, capital expenditure, share repurchases, and working capital management tell where the cash went. What managers should have been asking was whether the expectations of future profitability, and future profitability itself, are enough to match the funding demanded to raise one and deliver the other.

The fourth is investors required return. As stated before, this is the key challenge for all companies.

Balancing these four aspects of Wealth Added has the potential to reap enormous benefits, and it has never been more important. It may be easy to boost profitability over a given period by concentrating on the drivers of profitability like sales or margin, but in doing so, prospects may be sacrificed. Alternatively, a company may spend so much to purchase profitability and/or prospects to get the share price up that financing on a grand scale is required from investors. The cost of this must be factored in to the equation.

Let's probe this a little further. To better understand and analyse the results, we classified the companies under three broad segments.

• The Fallen Angels (HLL, Zee Telefilms, ITC, Nestle): Once stockmarket darlings, these companies have fallen out of favour now, even while continuing to deliver sound operating results year-on-year. The better the management continued to perform, the more the market expected from them. The expectations were simply moving too fast, and eventually these companies just could not keep up with the required pace.

• Today's Darlings (Infosys, Wipro, Ranbaxy...): These companies have handsomely exceeded investor expectations over the last five years-but to remain an extraordinary performer over the next three to five years will require them to continue to exceed the increased market expectations embedded in their stock prices. These companies will face significant challenges to continue the performance momentum going forward over the next 5-10 years.
• The Unsung Heroes (TISCO, Grasim, GAIL, Nalco, MRPL, Neyveli Lignite, SCI, Tata Power): Often considered as unfashionable sectors to invest in, these companies managed to significantly exceed the wealth flow expectations of their investors by sticking to the basics-improving operating margins through sound cost management and pricing strategy, enhancing asset productivity through better asset sweating and working capital management. Having honed their operating efficiencies to the ''stretch'', the challenge for these companies lies in developing and managing future growth prospects, (such as transferring core competencies to new business areas or related value chains, foraying into new geographical markets). One plausible explanation for their out-performance is that many of these companies may have found it easy to outperform the low imputed expectations of fundamental performance improvement embedded in their historical valuations. It seems unlikely that they can continue to outperform the current investor's expectations over the next 5-10 years merely through squeezing more out of their operations.

Looking Beyond The Numbers

So what does it all mean to the practicing manager? Our study unfolds a number of messages that are resoundingly clear and encouraging:

You can exceed investor expectations, regardless of industry sector, market or profitability level.

Nandan Nilekani/President & CEO/Infosys: A better past than a future?

Companies like Infosys face an uphill task meeting high expectations

Our study reveals considerable dispersion in the wealth added performance recorded by companies during the five-year period. Some companies in under-performing industries put in spectacular performances, and some companies in over-performing industries didn't. The findings indicate that over the medium to long term companies can exceed investor expectations, regardless of the industry sector, or current profitability. Exogenous forces will, of course, have an impact, but the encouraging news for chief executives is that companies can actively manage the level of wealthflow that they create to shareholders.

But for a few exceptions, successful value creators always seem to ''Earn the right to grow'' i.e. they build profitability first, and then go for growth.

Companies, that are seeking to ramp up their performance, often face conflicting options. Should they seek to grow out of the problem? Or should they focus on their existing assets, divesting some and harvesting the profitable ones? This trade-off is not evinced in the value creation trajectories of top performers. Our study reveals that the largest wealth creators seem to focus on enhancing operational efficiencies first, to a point, where the Returns on their Invested Capital are comparable to the Cost of Capital, before switching their emphasis to growth. Thus when growth opportunities decline, the value creators are able to put in a superior performance.

Besides managing for profitability, the largest value wealth creators manage the value of prospects much better than their peers (see Top Wealth Creators Vs Industry Peers).

Our study reveals that when it comes to enhancing the value of prospects, the best value creators are always a step ahead of their peers (ONGC seems to be a rare exception to this observation). True, every sector, by virtue of the competitive forces and their stage in the life cycle, can lie along at different points within the profitability-prospect dimension; however every sector offers adequate scope to build growth pipelines that can be harnessed in the future. What the study results reinforce is that wealth creators need to continually think through the drivers of their future prospects and possibly maintain a roster of leading indicators that adequately proxy for their value generating capability in the future.

Brian Tempest/CEO-Designate/Ranbaxy: It's an expectations game

Ranbaxy's key measure of prospect build up will be the number of ANDAs

The treadmill of investors' expectations makes it hard for top performers to remain on top over a long period (see IT Sector: Bumpy Ride Ahead?).

Managers face a tough challenge to consistently exceed the wealth flow expectations of shareholders. Our study reveals that very few companies, even amongst the best performers, have been able to exceed the expectations for each of the five years in a row. Deciding the length of a shorter-term period is arbitrary, and the list of top performers for any one or three-year period would be different. However, as in the case of HLL, a more recent wealth added performance might give a precursor of things to come over the medium to long term. The findings reveal that as in the case of FMCG sector, alarm bells may need to be tolled for the it sector as well; for although the sector has exceeded the wealth flow expectations over the five year period, the more recent wealth flows have not matched expectations. And despite the recorrection in sector valuations during 2001, the players will face significant challenges to deliver on the current embedded expectations.

Key Takeaways For Chief Executives

How can companies hope to make it into and/or stay within the list of the top 100 wealth creators for the next five to 10 years? CEOs can systematically apply a simple set of principles to maximise the wealth flow to the shareholders. Here are a few success factors that apply to all companies.

Set a target intrinsic value for the business and an explicit wealth flow goal on the intrinsic value. Manage your businesses for their long-term target intrinsic value that is based on fundamental valuation and driven by long-term expectations, but detached from the short-term vagaries of capital market gyrations. Market expectations or peer multiples can at best be one of the guiding factors in helping build a consensus estimate on the target intrinsic value that you should be managing the business for.

Debate priorities and trade-offs between alternative strategies for maximising wealth added. Making a strategic choice involves making trade-offs between investing in the long-term value of prospects and boosting short-term profitability, which vary greatly by industry, and the competitive position of the business. Businesses with high-prospects (e.g. pharma, it) need to not only deliver on medium term profitability growth but also continue to systematically build the value of their long-term prospects. Most importantly, keep the shareholder's investors' risk appetite and confidence of eventually earning above cost of capital returns on their incremental investments in mind. An explicit wealth flow target provides an anchor for the strategic choices. If the current portfolio of strategic choices cannot meet the wealth flow aspiration, be prepared to change the action, not the goal.

The Stern Stewart team: (Front row, L-R) Kumar Subramanian, Tejpavan Gandhok (Regional Director, South East Asia & India), Suramya Gupta; (Second row, L-R) Sanjay Srimoyee Kukherjee, Anurag Dwivedi

Manage medium-term performance relentlessly and design equity-linked rewards carefully. Once the long-term wealth creation goal and the path to get there are crystallised, set challenging intermediate milestones for line-managers to drive medium term performance. Rely much more on fundamental measures of profitability that are linked to investors' long-term expectations but free from the short-term vagaries of capital market sentiments. If boards choose to use equity rewards for CEOs and senior management, they should carefully consider the wealth creation performance targets and lock-in mechanisms over time horizons that are long enough.

Closely monitor your prospect build-up. Complement your monitoring of profitability with appropriate leading indicators tied to the value of long-term prospects. For ONGC, the key measure of prospect buildup could be growth in proven reserves while for Ranbaxy it could be the number of Abbreviated New Drug Applications (ANDAs). Savvy investors and analysts already keep a close watch on such lead metrics and factor them into their target valuations. Do you?